The Cost of Cash: Talking to Clients about their Cash Allocations
Text on screen: PIMCO
Text on screen: John Nersesian, Head of Advisor Education
Nersesian: Hi everybody. I'm John Nersesian, head of advisor education at PIMCO and I'm so pleased to be joined by my colleague Jerome Schneider. Jerome is a managing director with PIMCO here in Newport Beach, and he's the leader of short-term portfolio management. Couldn't pick a better guest for this conversation on moving out of cash.
So, as we all know, after a number of increases by the Federal Reserve Board over the past few years, we've seen a significant spike in short-term rates and investors, of course have taken notice of this increase in short-term rate opportunities, moving over $800 billion into money market funds this year, reaching an historic high,
Text on screen: TITLE – Rise in cash balances; SUBTITLE – Substantial growth in money market funds (2003-2023)
Image on screen: A mountain chart shows money market assets under management (AUM) from 2003 – 2023. The mountain shows a spike in AUM leading up to and during the global financial crisis. After AUM dropped in 2010, it stayed relatively stable at around 3,000,000 until 2018 when AUM began to rise higher. AUM peaked in 2020 at roughly 5,200,000 and then bounced up and down until reaching the its highest level in history (roughly 6,000,000) in 2023.
of over $6 trillion in balances today and while investors may be seduced by these attractive short-term rates, are they missing a longer term opportunity for questions like this and others we're gonna turn to our friend Jerome. Jerome, thanks again for spending some time with us today.
Schneider: Great to be here. Thank you for the opportunity.
Nersesian: So, let's start first, Jerome, with this concept. Investors have often suggested that they need to keep cash in their portfolios, and there are obviously valid reasons to do so.
Image on screen: image is a quote that reads, “I feel like I need access to cash. I need liquidity in my portfolio to meet my cash needs.”
How would we counter that particular argument or objection.
Schneider: For investors the rationale of being defensive is one that has a knee jerk reaction to something that's happened in the recent past.
Text on screen: Jerome Schneider, Head of Short-term Portfolio Management
That recency bias of what's happened in 2022 is really at the forefront of people's mind in terms of reaction function of 2023 and beyond, and has garnered a significant amount of capital, as you note to historical proportions and money market funds. That's a defensive posture.
And while today we're seeing average money market fund yield 5%, it's not necessarily the right approach to capital investing and taking a capital preservation approach for their capital. While we might have a little bit of uncertainty with regard to monetary policy, fiscal policy, even the economic outlook over the next 24 months, what we wanna do in this discussion is really set forth for investors the structural opportunity about how to think about their cash, perhaps tier their cash given different liquidity horizons and make the most of putting their cash to work for their benefit.
And ultimately, this environment is one that yes, you can embrace the higher yields in cash and money market funds, but there's also structural premiums, structural returns, which investors need to be made more aware of, which requires an active management approach to cash in this environment where we do see opportunities, even though a more defensive posture could put, could potentially be warranted.
Nersesian: Makes sense. And I love the term that you've often used, which is something that I think is new to many people, which is not all cash is the same. Investors often look at cash as a singular asset class,
Image on screen: image is a quote that reads, “I don’t want to take risk with my money now. I’m trying to protect my principal and focus on capital preservation.”
but you go to great lengths to really define how cash can be invested in different ways. Can you speak to that?
Schneider: Absolutely. For investors, clearly who are focused on cash and cash allocations, it's all about capital preservation. And to understand what capital preservation means doesn't necessarily mean that you need to take liquidity risk from a day-to-day basis. In fact, what we suggest is you need to rationalize and separate the difference between capital preservation and the opportunity to put your liquidity to work over periods of time. And in doing so, we call this a tiered approach.
Text on screen: TITLE – Cash Tiering
Images on screen: At the top is an inverted triangle cut into threes sections. The top wine colored section reads, Return driver “traditional fixed income”;’ the middle green-colored section reads, Capital preservation “Short-Term”; the bottom blue colored section reads, Traditional cash – “money market”. To the right of the inverted triangle there is copy that lines up with each section of the inverted triangle. The top wine colored copy reads, TIER III, Purpose: Used for excess liquidity and long-term spending needs, Horizon: Multi-year. the middle green-colored copy reads, TIER II, Purpose: Enhance returns to cash, liquidity buffer, Horizon: Intra-year. The bottom blue colored copy reads, TIER I, Purpose: Used for daily expenses, liquidity needs. Horizon: Daily, intra-month.
Understanding that the first tier of liquidity management is for immediate cash needs over the next day, the next week, perhaps even the next one to two weeks, and then move to a second tier for the remaining allocation over the course of the next few weeks, the next month, the next several months, maybe in the next year or two. And in doing so, you're able to, capture additional premiums, additional returns that are beyond the money market space.
And so doing so, we wanna move investors from being a price taker, meaning the yields they're earning for putting their cash in a traditional money market fund, which is below the Fed fund's benchmark rates by 50 basis points or more, and then move into a tier of liquidity management, which is not only focusing on capital preservation, but also thinking about the potential returns given the liquidity profile that investors may have.
So said simply, if investors have a longer liquidity horizon and can define it, there are opportunities which allow them to capture more returns along the way, given a historical context.
Nersesian: This idea of capital preservation, which is a primary objective for so many investors and one of the objections that we're hearing from investors today is, John, let me remind you that 2022 was not a fun year. You know, volatility in all risk assets in fact, over the past 40 years, we've seen only one year,
Text on screen: TITLE – Many Investors Have Never Faced a Year as Challenging as 2022; SUBTITLE – Annual returns for stocks and bonds since 1977 (%)
Image on screen: Scatterplot has four quadrants: Upper left reads Stocks lost, Bonds gained; Lower left reads Stocks lost, Bonds lost; Upper right reads Stocks gained, Bonds gained; Lower right reads Stock gained, Bonds lost. Most of the plot points fall in the upper right (Stocks gained; Bonds gained) quadrant with only a few years falling into the lower left (Stocks gained; Bonds lost) quadrant. Eight plot points, or years, fall into the upper left (Stocks lost, Bonds gained) quadrant, and only one year 2022, falls into the lower left (Stocks lost, Bonds lost) quadrant. To the left of the scatterplot chart is a box that reads: Bonds have historically performed well during periods when stocks did not.
one period of time where stocks and bonds decline simultaneously and that, of course, was in 2022.
So, some recency bias at play, if you will, investors remember those negative experiences last year, they're somewhat reluctant to redeploy some of that cash today. How would you respond to that? How would we encourage clients to think about opportunities to redeploy cash given the recent
Image on screen: image is a quote that reads, “Bonds underperformed last year, Why should I invest in them now?”
negative returns that they may have experienced in other asset classes?
Schneider: Absolutely, well, the rationale is that we are in a different environment. The landscape has recalibrated. We're finding ourselves in a world that not only are we at, beyond the 0% rates and the negative rates we've seen around the world for the past decade or so, but now we're in a positive rate environment, both in a nominal term and also a real inflation adjusted sense.
And so, it's quite an attractive entry point for investors to start to begin to think about the fixed income allocation. So, what we're suggesting is, at this point in time for investors to think more actively in terms of how they're going to do this, historically people have done this by, assuming when rates moved higher, they sort of did it from a method of laddering, taking a systematic approach to reinvestment. That's not necessarily the right approach at this point in time.
It's agnostic of risk taking, it's agnostic of credit risks, it's agnostic of structural risks and what we're saying in this uncertain environment where you could potentially have an economic outlook, which is a little bit softer than the market is suggesting at this point in time, we wanna be thinking about how to create a balanced approach, but also a nimble approach.
One that takes into account not only credit and credit risks, but also looks at the structural opportunities that might avail of themselves. So as an example of this, we find great opportunities, even in our highest quality, most defensive capital preservation strategies to think about asset-backed securities as a diversifier. AAA high quality asset-backed securities are a diversifier away from corporate credit risk.
And as such, those are opportunities which an average investor may not necessarily see in terms of a laddered approach or a systematic approach, but a more active approach allows an entry point to begin to pivot and find those opportunities beyond the traditional sense of laddering to a CD or a traditional T bill program.
Nersesian: I mean, it's so interesting for so many investors, they were so anxious to reach for yield when rates were at 1%. Today we're starting at five-ish
Image on screen: image is a quote that reads, “I think rates could continue to rise. I’ll wait until rates stop rising before I invest in bonds again.”
and now of course investors have a greater opportunity, but they seem to be a little bit more reluctant to redeploy their capital.
Schneider: We wanna make sure that for your cash is working for you in this environment. And for so many years, cash was a drag, cash was talked about as being deadwood, zero rate returns sort of created this lethargy of really not really managing your cash actively.
We're an entirely different environment now, and in fact, one where you can utilize cash not only as a defensive mechanism, but also as an offensive mechanism, as a potential pivot to earn structural premiums as a potential pivot to when recalibrations happen in the broader marketplace, reallocating the capital, and then fundamentally to thinking about cash as a volatility suppressor in a more volatile environment.
If you're able to earn returns, which are not just 5% or so in a money market fund, but six to 6.5% by being in a short-term type of strategy with a limited amount of interest rate exposure, that actually presents an opportunity not only to put, dip your toe in the water of fixed income, which is more attractive today, but also do so in a way which should have a less meaningful allocation to volatility that the broader marketplace might have given the uncertainty of economics, given the uncertainty of monetary policy outlook. And obviously fiscal outlook is something that is growing in the concerns of many people, including PIMCO, on the more secular basis.
So, think that this is a good opportunity for investors to not only rationalize and higher allocation of fixed income to get back to a benchmark allocation per se, but also take advantage of the structural opportunities we see on a go forward basis to make the cash work for you. And so, this is a good opportunity to start rationalizing that pivot.
Nersesian: Yeah, that makes a lot of sense. Obviously given the volatility that the marketplace endured last year, clients may be sitting with positions that are underwater, right. Trading at prices below what they originally paid, and that creates an opportunity for tax loss harvesting, something that many advisors and investors look towards as a way of generating better outcomes.
Image on screen: image is a quote that reads, “How should I think about harvesting losses in my portfolio?”
What role might tax loss harvesting play in this opportunity to take advantage of the higher rates available today?
Schneider: Well, we find it in a number of regards, but really what we're finding and having discussions with investors is those investors who had been traditionally under allocated over the past decade to fixed income, we're finding that the conversations are being fruitful, but yet they may not necessarily be convicted for some of the reasons we laid out at the outset of this conversation to move directly into fixed income.
What tax loss harvesting does is gives you additional cash, additional capital to pivot and perhaps start to think about how to rationalize and taking advantage the recalibrated yields and total returns in fixed income.
But yet investors might still be cautious for adding interest rate duration, considering where they were in the environment and so while at PIMCO, we believe that there is opportunities right now where we have current, current rates within the yield curve that are attractive.
Investors might just simply want to dip their toe in the water and being in a short duration strategy with three years or less interest rate exposure, allows them to participate some of these premiums that we discussed previously, and at the same time, still be conservative enough not to be so concerned about where interest rate exposure is, if it should be going to the upside and at the same time, if we do experience a hard landing and the Federal Reserve becomes more defensive, more dovish and proceeds to be have a monetary policy, which is much easier, you're gonna benefit from some capital appreciation in that regard too.
Nersesian: That makes a lot of sense. Jerome, thank you so much for sharing your expertise with us today. Very beneficial. Very opportunistic, given the current market environment. And I wanna thank our friends for spending some time with us today. We hope that you enjoyed the conversation. We wanna encourage you to contact your PIMCO account manager or to visit us at PIMCO.com for more information.
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